Risk is ‘out’ and will remain so
The previous blog focused on how so many supposedly smart people and famous names from among the professional investment community could have been taken for a ride by Bernie Madoff’s scam. The inescapable conclusion was that they were guilty of either stupidity, or incompetence, probably mixed up with a good dash of either arrogance or laziness. These sterling qualities, rather than outright villainy and criminal intent, are likely to have been the cause in the great majority, if not all, the cases.
So what? Where does that leave the huge profession of money management, which has grown so massively over recent years – indeed, over the three or four decades since private wealth started to expand rapidly? Will the money managers be able to put the crash and the scam behind them and get back to what they like to think of as ‘business as usual’?
The answer is NO. As 2008 comes to an end – not a moment too soon for most money managers, their profession stands exposed as an overgrown, under-regulated mess. Everyone – that is to say investors large and small, and government agencies and regulators of every stripe – are going to home in on money managers, like sharks on a wounded creature floundering in the water. Roles are being exchanged, the hunter is now the hunted, its victims seeking revenge.
The result will be a huge shake-out and general contraction of this bloated sector. Many firms will be driven out of business completely and many – I would think most – of the people who lived handsomely from it in 2007 will be gone by 2011. Modes of operation that were formerly mainstream and hugely profitable will be made illegal or so closely regulated as to be rendered unprofitable. Most of the smart people and all the whizz-kid adventurers will leave or be thrown out. What will remain will be boring, stodgy and – for the most part – safe. To have no crooks and con artists at all is impossible, but those that will still operate in the new environment will be fewer, less daring and therefore less dangerous.
With regard to specific sectors, it’s pretty clear that private banks are going to have a hard time. Their old bread-and-butter business, managing ‘offshore’ wealth for rich foreigners, is already the target of a global war being waged by the major economies, led by the US and EU, against the myriad offshore centers that have sprung up over the last 20 years. Switzerland has been effectively neutered and its banking secrecy shot to pieces; Germany is currently engaged in a ruthless campaign to squeeze Lichtenstein out of existence as a funk-hole for dirty and dubious money; the Americans will clean up the Caribbean, island by island if necessary – all this because the era in which private wealth was considered sacrosanct is over and, more prosaically, because governments need every tax dollar that they can get their hands on, so loopholes that allow rich people to avoid tax by putting their money in offshore havens will be systematically closed down.
But the private bankers’ woes only begin there. Their turf will be invaded by all the (remaining) commercial banks, which will be looking for any and every opportunity to increase their revenues. With the number of rich people already sharply reduced by the market and housing massacre of 2008, and set to fall much further because of the deep recession of 2008-10, the combination of fewer customers and more competitors can only mean that the glory days of the private banks, from London to Singapore – and even to Dubai – are over.
But all that was true before Madoff. What this scandal has done is to mercilessly expose how much of the ‘wealth management’ industry, which included private banks and a host of boutique outfits offering advisory services, brokerage and a gamut of ancillary services to the well-heeled, was based on slick marketing and mutual back-scratching. So long as credit was readily available and the markets were pointed upwards, the profits on investments – especially when these were leveraged – was sufficient to feed all the service providers and middle-men, and still leave enough to keep the investors happy.
Now, with leverage gone and profits on any kind of investments hard to come by, most of the free-loaders are exposed for the parasites they always were. Very few were outright criminals, hopefully none on the scale of Madoff (but who knows what additional skeletons lie in closets around the world?), but the Madoff scandal has sensitized even the most docile and dopey investors to the kind of risks they may be taking when they hand their money over to ‘money managers’ of one sort or another.
So the entire fund management industry will be under the microscope. Instead of taking fat fees for doing little or nothing, it will be under intense pressure to take much less and provide much more – much more information, for starters and, ideally, much better performance, relative to market benchmarks. Since most of them are plainly unable to do the latter, and many are unwilling to do the former, they will fold and close.
Hedge funds, in particular, are doomed to disappear – at least, in the form we have come to know them over the last 10-15 years. Personally, I have always been mystified as to why smart and often very perceptive people, who had succeeded in walks of life from sport to scientific research, were willing to give their money to kids who took 2% a year as management fees and offered them the following deal: if the fund we manage makes profits, we’ll take 20% of them, but if things go badly, we’ll close down the fund, send you any remaining money and walk away – only to resurface somewhere else soon after and start another fund.
The collapse, during the crash of 2007-08, of the supposedly sophisticated and certainly complicated strategies used by many of these funds, has caused a wave of redemptions and closures. The latter are running at record levels and will increase further in 2009, slimming down this absurdly bloated sector and removing the phalanx of johnny-come-lately managers who jumped on the bandwagon since 2003.
Hedge funds will also be the target of a massive regulatory drive which will insist that they reveal their strategies, their holdings and their performance data, in a level of detail which will make most of them either unsaleable or unworkable, or both.
But the area that is likely to be worst hit, to the point of being effectively eradicated, is the fund-of-funds sector. The proposition sold by managers of funds-of-funds — whether these were funds of mutual funds, or of hedge funds, or of any other kind — was that in view of the huge and rapidly multiplying number of funds, investors needed an additional level of expertise in order to sift between them and sort them out. Fund-of-fund managers claimed to be able to identify the best fund managers and to be able to get their investors good deals with these demigods and stars.
It now transpires, as the Madoff scandal brutally reveals, that many fund-of-fund managers preferred to cut sweetheart deals with the fund managers in whom they invested; that they were too lazy or too stupid to conduct thorough – or even any – due diligence regarding the managers of funds in which they invested and how these funds operated; in short, that they did little or nothing to justify the extra level of costs they added.
Inevitably, the good, honest and efficient fund-of-fund managers are going to be tarred with the same brush as their lazy, stupid and corrupt colleagues. Some will give up the fight and quit the business whilst some may struggle on, but the overall outcome will the end of funds-of-funds as they have existed hitherto, because the business model for funds-of-funds has been shown to be uneconomical; in plain English – it doesn’t work..
Finally, private equity funds will also shrink in number, size and scale of operations. The absurdly huge deals they were mounting in the final years of the boom (until as late as the summer of 2007) have already disappeared into history. Many of the later deals will go bust over the next eighteen months, as the bonds that financed them come up for redemption or refinancing. Those that remain will still have plenty of business, once the markets stabilize, but they will have to make do with a rate of return on equity that would have been considered pitiful in the halcyon days of 2004-2007.
Is all this good or bad? No doubt the legions of true believers in the inherent efficiency of markets and the ability of deregulated capital markets to direct capital to its most productive uses, will launch a spirited defence of the modus operandi that characterised global capital markets in the 10-15 years that ended in 2007.
But these efforts are as pointless as they will be fruitless. The socio-economic environment has changed, dramatically and completely, as a vast shift in the psychology of the general public – and hence of investors and regulators – takes place. Risk is ‘out’ and will likely remain so for many years to come. Takers of risk, such as traders and fund managers, as well as facilitators of risk such as bankers and financiers, along with all the other players who have populated the financial arena in recent years, will cease to be role-models, heroes in the popular mind and media and objects of envy and esteem. They will become – perhaps already are – the focus of disdain, if not disgust.
This sea-change in the popular mood will find its clearest expression in the switch from ‘investing’ to ‘saving’. The difference between these concepts is far more than semantic, and I expect to revisit this idea frequently over the coming months.